The most delightful things in life are said to be free, and so are the cash flows! Who wouldn’t love companies that have plenty of free cash flows? Read on to understand its power in investment decision-making.
Free Cash Flow (FCF) is basically the cash that a company is able to generate after meeting its operational and fixed costs. In simple words, if your monthly income is Rs 25,000, but your expenses are only Rs 20,000, your Free Cash Flow is Rs 5,000. However, if your expenses exceed Rs 25,000, then your Free Cash Flow is negative. What would you prefer? The answer is obvious.
FCF is important for the companies as well as investors. Here’s how…
A better FCF indicates better efficiency on the part of the company. For a company, cash is like what blood is for the human body. Businesses, whether small or large, need cash to survive and grow. If a company is not generating enough cash, it will struggle to grow. Free cash flow is one of the most important indicators to evaluate the true performance of a public company.
Investing in long-term growth, through new product development, capacity expansion, etc. is often the best use of free cash flows for the company.
A company may do business on credit and show revenue and net profit even before receiving actual money. So, despite the profits, the company may actually have a cash shortage. It could affect its working capital cycle. So, net profit may not provide the true picture of a company. On the other hand, excess cash indicates a company's ability to repay debt, payout dividends, buyback stock and enable the growth of the business - all important undertakings from an investor's point of view.
You can calculate free cash flow from financial statements. The formula for calculating Free Cash Flow is Net Profit + Depreciation - Capital expenditure - Changes in working capital – Dividend.
For evaluating the attractiveness of a company – Similar to dividend yield, you can also consider Free Cash Flow yield while investing in stocks. Note that, the companies, whose FCF as a percentage of net profit is higher tend to trade at higher valuations.
Cash flows differ as per the dynamics of the sector in which it operates and should be seen in that light. While sectors like banking require minimum Capex, those in pharma, engineering, FMCG, or commodity sectors require to invest largely in R&D and expansions.
Asian Paints, Titan, and Page Industries are good examples of companies with a good track record of cash flows over the years. They have been relentless cash machines along with profits.
A negative free cash flow generation does not always mean weakness. When a company is in an early stage of a business, there could be more capital investments compared to operating profits. On the other hand, constant positive free cash flows do not always mean strength.
So, the key is to filter companies on Free Cash Flows along with other parameters like the management track record, growth rate of the industry, Capex plans, and debt levels, amongst others.
As they say, revenue is vanity, profit is sanity, but cash flow is the king!
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